Overcoming Basis Risk in Parametric Insurance

Abstract

Parametric insurance products are available for more than two decades now. These products do not indemnify pure loss like traditional insurance contracts but

make a near-automatic payout of a pre-defined amount when the parameter, index of parameters, or pre-modeled loss related to a risk event reaches a pre-determined threshold. The parameter or index that acts as a proxy for the actual sustained loss is an important determinant for the success of a parametric product. Any mismatch between the actual loss and parametric payout that arises due to issues in the parametric structure is termed as basis risk. The presence of basis risk reduces the effectiveness of parametric insurance as a risk management tool, creates a perception of parametric insurance being a poor substitute for indemnity insurance, and prevents its widespread adoption. This article discusses the types and sources of basis risk and the means for overcoming it.